Repeating Europe’s Charade?

There is every indication that markets will soon force Portugal to follow Greece and Ireland and request a bailout from the International Monetary Fund.

There is every indication that markets will soon force Portugal to follow Greece and Ireland and request a bailout from the International Monetary Fund (IMF) and the European Union (EU). By the time this happens, one must hope that the IMF will have learned from its disappointing experience with recent Greek and Irish bailout programs that the problems in Europe’s periphery are more of solvency than of liquidity. Such a recognition might spare Portugal from another of the IMF’s simple-minded, one-recipe-fits-all applications of severe fiscal austerity to address the country’s serious public finance and balance-of-payments problems.

Past experiences with IMF external support programs in Asia and Latin America have led to a temporary restoration of market confidence. In particular, they have generally resulted in a significant reduction in interest rate spreads to levels consistent with public debt sustainability and to an early resumption of economic growth. This has not been the case with either the $140 billion Greek bailout program of May 2010 or the $110 billion Irish bailout program of November 2010.

The problems in Europe’s periphery are more of solvency than of liquidity.

Indeed, by the middle of March 2011, interest rates on Greek and Irish sovereign bonds remained very close to their all-time highs. These high interest rates imply that, despite unusually large official bailout packages, the market continues to assign a high probability to these countries’ defaulting on their sovereign debt obligations within the next five years. They also imply the continuation of domestic credit crunches in Greece and Ireland that must be expected to exacerbate the adverse effects of sustained severe fiscal retrenchment on these countries’ economic growth prospects.

At the heart of the market’s doubts about Greek and Irish public debt sustainability is a deep skepticism about these countries’ ability to grow out of their public finance problems. This is particularly the case considering that continued euro membership precludes these countries from devaluing their currencies to boost exports at a time when deep fiscal retrenchment is undermining domestic demand. Recent disappointing economic growth performance in Greece and Ireland seems to lend considerable weight to the market’s skepticism.

The International Monetary Fund programs for Greece and Ireland are grounded in the dubious premise of the early resumption of economic growth.

Since embarking on its fiscal austerity program roughly two years ago, the Irish economy has contracted by at least 11 percent. Meanwhile, between the fourth quarters of 2009 and 2010, Greece’s economy declined by 6.5 percent, or at a significantly faster pace than that envisaged in the IMF program. This disappointing growth performance is eroding Greece and Ireland’s tax bases and sapping the political willingness in both countries to persevere with IMF-imposed austerity, as illustrated by renewed social tension. Yet despite these sharp growth declines and the further massive fiscal adjustment being imposed on Greece and Ireland over the next three years, the IMF programs for both these countries are grounded in the dubious premise of the early resumption of economic growth.

Yet another disappointing aspect of the IMF-EU bailout programs for Greece and Ireland is that they have not taken the European Central Bank (ECB) off the hook for keeping these countries’ banking systems afloat. The latest estimates indicate that by the end of January 2011, ECB rediscount lending to Ireland had reached around €180 billion, or the equivalent of around a staggering 100 percent of Ireland’s gross domestic product (GDP), while such ECB lending to the Greek banking system continued to hover near €80 billion. One would think that ECB lending at these levels is neither sustainable nor compatible with the ECB’s role as a monetary rather than fiscal institution.

Greek and Irish sovereign bonds’ high interest rates imply that the market continues to assign a high probability to these countries’ defaulting on their sovereign debt obligations.

Portugal’s presently high borrowing rates in the international capital market, coupled with its government’s high borrowing needs in the months ahead, makes it almost inevitable that Portugal must soon seek an IMF-EU bailout. So too does Portugal’s extremely weak external position, as underlined by a current account deficit that has averaged 10 percent of GDP over the past decade and a gross external debt that now stands near 230 percent of GDP.

Portugal’s interests would be poorly served if the IMF repeats the European charade that the periphery is suffering from a liquidity problem rather than a solvency problem. In devising a Portuguese rescue package, the IMF should consider the orderly restructuring of Portugal’s external public- and private-sector debt—an option it dismissed out of hand for both Greece and Ireland. Such an approach would be preferable to more denial, which could lead to an adjustment program for Portugal that causes the deepest of economic recessions and only increases the probability of a disorderly debt restructuring down the road.